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Do you have a client who habitually resides in and is domiciled in England, has already prepared a will, wishes to mitigate inheritance tax (IHT) and regularly has excess income?

If his estate is less than the nil rate band (NRB), or if he has the benefit of a full transferable NRB (TNRB) and his estate will remain so even if his surplus income is accumulated for longer than his life expectancy then there is no tax advantage to recording and reporting gifts out of income. But if he has more capital than the relevant NRB and TNRB available then consider how to utilise the normal expenditure out of income relief for IHT using gifts out of surplus income.

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The test

If he can show that gifts he intends to make:

Form part of his normal expenditure;

Would be made out of income, and;

Will leave him with enough income to maintain his normal standard of living;

Then the “normal expenditure out of income” exemption can apply to reduce his IHT liability from the time that the gift is made [section 21 of the Inheritance Tax Act 1984 (IHTA84)]; there is no need to survive seven years as with potentially exempt transfers. If this exemption was not used any excess income would be accumulated swelling the size of his estate and attracting IHT upon his death. By regularly making gifts of excess income IHT can be avoided, or significantly reduced, upon death.

It is noteworthy that HMRC:

States that “in borderline cases you should give him the benefit of any reasonable doubt” [IHTM14234].

Does not impose a monetary limit.

Permits the use of the annual exemption in addition to the normal expenditure out of income so that if part of the intended gift falls foul of section 21 IHTA84 then it could still be exempt, up to £3,000.

What is “normal”?

Normal should be given its ordinary dictionary meaning and is to be construed subjectively. In Bennett v IRC [1995] STC 54 Lightman J held, after reviewing A-G for NI v Heron [1959] TR 1, that:

“…the term normal expenditure connotes expenditure which at the time it took place accorded with the settled pattern of expenditure adopted by the transferor.”

From Bennett there are five parts to the normality test as expressed by HMRC. Your client has to prove each condition. Two matters cannot be overlooked: evidence of a settled pattern and the intention of the donor (or his attorney). Supporting evidence is vital to (i) avoid lengthy and costly arguments with HMRC and (ii) obtain the IHT exemption sought.

Online banking makes obtaining evidence simple. Collecting and collating the evidence is vital to easily pursuading HMRC that the normality test is satisfied. A simple excel spreadsheet should ideally be kept by him of his normal expenditure and the gifts. The headings should enable the IHT 403 to be completed on death and sufficient narrative should ideally be recorded under each heading for each gift.

Frequency

Regular or annual gifts are not required. A system or pattern of giving can be evidenced by either an analysis of his past expenditure or he may be able to show the existence of a prior commitment or that he adopted a firm resolution, regarding his future expenditure and thereafter complied with it.

There is no fixed minimum period during which the expenditure must have occurred. A single gift may qualify (e.g. the first premium paid under an insurance policy or the first payment under a deed of covenant), or part thereof, if there is evidence that the gift was intended to be the first in a pattern (i.e. a declaration from the donor informing the donee of the intention to make a series of gifts) and that there was a realistic expectation that further payments would be made (i.e. he (or his representatives) would have to show that he thought he would survive long enough for such payments to be made and/or that in the premise this was an unforeseen circumstance; thus his life expectancy and health are also important evidential issues to address and death bed expenditure is very difficult to prove) in order for any payment fairly to be regarded as a regular feature of the his annual expenditure. There is also scope for accumulated income forming a single gift [see McDowall supra]. Usually HMRC will look at blocks of three years to see if patterns emerge; but there is no set time frame.

Amount

Comparability in size is important to HMRC but uniformity is not required. In my view comparability is impossible to balance with the facts and judgments in Bennett and McDowall and it is certainly a view that HMRC would struggle with in courts/tribunals. Gifts can be referenced to a source of income that varies or fluctutates (e.g. dividends) or for a particular purpose that usually increases (e.g. school fees). Or it can simply be all excess income as in McDowall. What HMRC seek is proof that the figures can be quantified and are systematically chosen because these two factors assist in proving a settled intention to make gifts out of expenditure with some regularity. An exceptionally large profit or bonus could satisfy the conditions if usually this was the basis of the gift because there is no need for the expenditure to be reasonable or that the expenditure is such that an ordinary person might have incurred in similar circumstances. Alternatively an unusually high gift may be partially allowed.

Nature

Payments should be made to the donee or made on their behalf (i.e. direct to schools). Documentary evidence should be retained especially if it is the latter. Gifts of capital or capital assets are not permitted under this exemption unless the capital asset is purchased out of income with the intention of making the gift e.g. gifts of cars, jewellery and other chattels. A share in a business may be a difficult gift to prove.

Identity of donees

The individual recipient need not be the same however, comparable categories of donees should be considered together e.g. family, charities. A discretionary trust for his spouse and all children would be acceptable. If the category is altered often this will terminate a pattern and it would be up to him to establish a new pattern of giving.

Reasons

It is not a requirement that the commitment be legal, religious or moral. If habitually he has given to those in need, be they charities, family or others then this could assist in identifying the category of donees and proving the conditions. In Bennett it is stated that “the fact that the objective behind the expenditure is tax planning…is no impediment.” Conversely gifts for special purposes (i.e. upon marriage) may not satisfy the condition and be left out of the equation because it would be unusual for the same to be capable of establishing a pattern.

What is “income” for these purposes?

As income is not defined in the IHTA84 normal accountancy rules should be applied but it is not necessarily the same as income for income tax purposes. Annual income is usually obvious but some regular receipts are capital e.g. receipts from a discounted gift scheme [IHTM20424] or insurance policies [IHTM14250]. Further if income is retained and accumulated there comes a point in time when it becomes capital; HMRC’s guidance is that this is after two years [IHTM14250]. However, it is the author’s view that income can be accumulated for longer if for a specific stated purpose (i.e. it would be wise to use an appropriately named account) or if it has not been invested but simply transferred from a current account to a deposit account [see McDowall supra]. It is noteworthy that HMRC accept that this is a contentious area, so expect an argument if you seek to push the boundaries. If the client’s income fluctuates (perhaps because he is self-employed) it is important to look at the average position over a number of years not just two and this scenario would be a good reason for accumulating income over such longer period.

In McDowall v IRC [2004] STC (SCD) 22 the Special Commissioners found obiter that income accumulated over 3 to 5 years in a current account and later transferred to a deposit account was still income.

Permanent changes to income (or its use) need to be considered and planned for i.e. the need to pay care home fees in later life when income may be restricted to pensions [see Nadin v Inland Revenue Commissioners [1997] SpC 112 & Stevenson v Wishart and others (Levy’s Trustees) [1987] STC 266]. There are a plethora of plans designed, in return for a single capital payment, to pay for care fees direct to the home on a periodic basis. HMRC’s view is that these payments are not income but partial returns of the one-off capital purchase payment [IHTM14250]. Conversely HMRC accept that the care home fees are part of normal expenditure. In my view, in the appropriate factual matrix this issue is open to challenge if the plan, details of the original premium and details of the payment(s) made to the care home expressly permit the construction that they are made out of surplus, perhaps accumulated, income.

Again keeping evidence of income is fundamentally important in order to prevent lengthy and costly arguments with HMRC. If the client is employed with regular or slightly increasing income then payslips would usually provide the answer without more. If however, he is self-employed and/or derives income from a number of sources then a similar schedule should be keep in excel to cover all sources of income and then both gross and net figures.

What represents a “Usual standard of living”

Subjectively it is important to ascertain what this standard is and to require it to be funded from income not capital. Initially it is important to consider the same year that gifts are made in. However, in light of fluctuating income one should then consider taking one year with another i.e. looking at averages. Evidence of income and normal living expenses should be considered by reference to the usual accountancy rules; perhaps IHT403 form on lifetime gifts would be a good proforma to adopt/adapt for this purpose.

He is not required to spend income on usual living expenses; he may choose to spend capital. It is sufficient to demonstrate that the normal expenditure gifts and the usual living expenses could be met from income. Again schedules of what is his usual standard of living are required. In essence this is evidence of expenditure for his position in society. Try and remember all aspects of everyday spending from mortgage/rents, utility bills, council taxes, car costs, food, toiletries, hair, dental, health care, prescriptions, TV/sky/internet/phone costs, mobile costs, technology costs, school fees, presents, flowers, magazines etc. The list is likely to be extensive and much will be repeated on a regular basis so the task of maintaining a schedule will become easier.

If there is a deficit then the exemption may be available in part.

If there is an unforeseen reduction in income, e.g. upon redundancy, it is often a case for negoitation with HMRC as to what is an acceptable level of surplus income but it is important to note that one has to look at the time the gift was made. If the gift was made at the beginning of year which was planned to be normal (as before) but turns out to quite different (due to an unforeseen change in circumstances) it is certainly arguable that there should be no reduction in exemption. Great care should be taken about gifts made after the drop in income is known as it is likely that he would not be able to satisfy this condition.

Practical Points

It does not follow that all gifts are exempt if these conditions are satisfied. The exemption does not apply to gifts made on:

Death

Termination of a qualifying interest in possession in settled property

Premiums for life policies linked to annuities if they are back-to-back arrangements made after 13th November 1974 [sections 21(2) & 21(3) IHTA84 & section 423 Income Tax (Trading and Other Income) Act 2005]

Capital asset transfers unless, exceptionally, these were purchased from income for the specific purpose of making the gift and they satisfy the other conditions

And even if he qualifies the gift may still be liable to IHT under the gift with reservation of benefit rules despite the fact that usually exempt transfers are specifically excluded [IHTM04071 & IHTM14231]. Note the omission of this exemption in section 102(5) of the Finance Act 1986 as amended. Your client should be excluded from reserving any benefit under any trust or settlement. Specialist advice should be sought about drafting such documents.

If the client satisfies the conditions; what next?

As your client has to prove that the exemption applies [section 21 IHTA84 states “to the extent that it is shown” i.e. shown to HMRCs satisfaction] HMRC seek, upon death a completed IHT403 or if in trust IHT100, so that the availability of the exemption can be agreed [IHTM10652]. It is thus important to work back from this position with your client for two reasons (i) it permits the client to explain the requirements to the intended executor and (ii) it forces the issue of collecting, collating and recording the evidence to support his position as set out above. It also seeks to highlight which other lifetime gifts do not fall within the exemption so that other exemptions should apply.

Conclusions

If the client’s intentions are firm then work out from contemporaneous documentary evidence the cost of his standard of living, income and then surplus income. Consider how the gifts are to be made and to whom. Are declarations and trusts required to mitigate further taxes? Should additional specialist advice be sought? Consider how records are to be kept and who is to keep them. The financial and fiscal positions of the donees should not be overlooked but are beyond the scope of this summary.